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August 22, 2011

Recession Priced Into Treasuries, as Yields Near Historic Lows

Droves of investors continue their stampede into U.S. Treasuries despite S&P downgrade

Investors’ flight to safety into U.S. Treasuries has driven yields toward historic lows and has market participants pricing in a recession.

“Research on the impact of uncertainty on the economy underscores the dangers of extended market turmoil. We now see a 40% chance of recession within the next 12 months,” wrote Bank of America Merrill Lynch economists Ethan Harris and Neil Dutta in a macro viewpoint published Friday.

The BofA Merrill economists added that “perma-bear economists” tend to see recession around every corner, even though history shows that “the steady deleveraging we are seeing in the U.S. is associated with slow recoveries, not double dips.” The larger concern, they say, is “uncertainty shock” driven by policy makers in Washington and Europe.

Also pointing to recession was LPL Financial Market Strategist Anthony Valeri in a weekly bond market commentary published last Tuesday. The Treasury market’s pessimistic message is clear, he said, noting that droves of investors are continuing to put their money into U.S. debt despite its Aug. 5 downgrade to Double-A+ from Triple-A by Standard & Poor’s.

“Treasuries moved to price in a recession following a volatile week in financial markets that led to strong safe-haven related gains,” Valeri wrote. “The downgrade of Treasuries to Double-A+ proved to be inconsequential to bond investors as Treasury prices surged and yields fell by 0.1% to 0.3% across the maturity spectrum. The 10-year Treasury yield fell to within a few basis points of the 2.06% low achieved during the fall of 2008.”

At this rate, Valeri added, the price on the 10-year Treasury has increased at a rate that would put the yield at zero by mid-October. “Such a pace is unsustainable and we believe the Treasury market may have overshot,” he said.

Taking a historical perspective, Asset Dedication President Brent Burns (left) said that with yields on the 10-year Treasury bond having dropped below 2.1% late last week rates are approaching the record low of 1.95% reached back in January 1941. Asset Dedication is a Mill Valley, Calif.-based portfolio engineering firm and an affiliate of BondDesk.

“In fact, the only time rates were lower than they are today was just before and just after World War II. Rates on the 10-year Treasury bond have been lower less than 2% of the time going back to 1800,” Burns wrote in an email, attaching a chart that shows 10-year bonds hovering around 2.00% just after the Great Depression of the 1930s as well as just after the post-Civil War period of the Long Depression at the turn of the last century (see chart).

Where will rates go from here? Burns reckons that since that there is not a lot of room for rates to continue to drop, there are just two options: up or sideways. And by sideways, he means flat—for a long, long time.

“There is plenty of precedent for prolonged periods of low flat interest rates,” Burns wrote. “Following the Long Depression (1871-79) and the Great Depression (1929-33), interest rates stayed low for decades as the economies of the time struggled to recover. The Federal Reserve Bank, last week, issued a statement that they would keep short-term rates low through at least mid-2013, adding to the likelihood of continued low rates. Japan has seen interest rates below 2% since 1997, which will likely continue for the foreseeable future as they struggle to recover from recent natural disasters.”

What should investors do? Burns said individual bonds are a better bet than bond funds, explaining that investors are extending further out on the yield curve to capture more yield. Doing so in a bond fund exposes investors to risk of loss when rates rise, he said.

"That’s the Catch-22. Stay short and earn nothing, but protect against larger losses or extend out to earn higher yields and expose yourself to bigger losses when rates rise," Burns wrote. "Although it is hard to see it with yields so low, this market highlights the real advantage of individual bonds. Investors can move out on the curve and pick up the greater yield, but if rates rise, they don’t have to sell. Instead, they can simply hold the bonds to maturity and receive the YTM on the bond as the worst case. In fact, the individual bond is very predictable, which makes planning easier since worst case returns are known from the beginning and are positive."

For another look at how Treasuries are being poriced in, check out this article on the upcoming meeting of central bankers.